China Law Insight : China Law Insight: China Commercial and Intellectual Property Lawyers and Attorneys, Full Service Law Firm: King & Wood

1  Governmental Structure

1.1 China's Political System

Political System of China refers to the political structure, fundamental laws, rules and regulation and practices that are implemented in China, and which control the state power, government, and the relationships between the state and society.  Being a socialist country, based on the worker-peasant union and practicing people's democratic centralism, the primary system in the country is the socialist system.

The main political structure of the PRC is comprised of two vertically integrated, but interlocking institutions: the Chinese Communist Party (the "CCP" or "Party"), headed by the Party Politburo and its Standing Committee; and the state government (the "state" or "government") apparatus, headed by the premier, who presides over the State Council, a de-facto cabinet.  Throughout China, Party and government structures closely parallel one another, with Party committees and representatives present not only in government agencies, but also in most organizations and institutions, including universities and foreign owned enterprises.

Two other major institutions play roles in Chinese politics.  One is the National People's Congress (the "NPC").  According to the PRC Constitution, the NPC of China is the highest organ of state power.  Its highest officers are the president and vice president of the NPC, who are directly elected by the members of the NPC.  Articles 85 and 92 of the Constitution state that the State Council is the executive arm of the government and reports to the NPC.

The other is the Chinese People's Political Consultative Conference ("CPPCC").  The CPPCC is an organization of the patriotic united front of the Chinese people.  It is also an important organ of multi-party cooperation and political consultation under the leadership of the CPC, and an important instrument of democracy in the nation's political life.  The CPPCC exercises the functions of political consultation, democratic supervision, and participating in the administration and discussion of state affairs.  This is a key link for the CPC and the governments at all levels to ensure that decision-making is scientific and democratic.

Another key institution in Chinese politics is the People's Liberation Army ("PLA"). The distinction between civilian and military leadership in the PRC is tenuous. There are, for instance, two authoritative bodies ostensibly tasked with authority over military policy and decisions: the Central Military Commission of the PRC, a state entity; and the Central Military Commission of the Communist Party, a party organ.  Although the former is nominally considered to be in supreme command of military and defense affairs, including the formulation of military strategy, in reality it is the Party-controlled Central Military Commission ("CMC") that exercises command and control over the PLA.  Since the membership of the two 11-member commissions is usually identical, it has become customary to refer to the CMC alone without distinguishing between the two.  The CMC is chaired by the Party general secretary, emphasizing that leadership of the military is a Party prerogative.

1.2 Government

The PRC is governed under the leadership of the CCP.  The PRC government is organized in two tiers.  The central government, State Council is the highest administration authority of PRC and leads various departments, bureaus and public service units, while local governments have authority over the provinces, autonomous regions, centrally governed municipalities (Beijing, Shanghai, Tianjin and Chongqing), and special administrative regions (Hong Kong and Macau).

The PRC's legal system, administrative apparatus, policy-making and government organizations are broadly divided into three levels, namely, the central government level, provincial or municipal government level, and local municipal or county government level.  Foreign investors need to understand which authorities are relevant to their particular activities and it is important to appreciate that the role of government is very significant in PRC business matters.

1.3 Foreign Investment Approval Authorities

There are several authorities responsible for overseeing different aspects of foreign investment through their central and local branches.

(a) Project Approval involves the National Development and Reform Commission (the "NDRC")

The NDRC co-ordinates development policy and also takes a major role in approving foreign investment projects.  Along with the project approving procedure, opinions from other relevant authorities (such as the opinion from the Ministry of Environment regarding the environmental protection for a plant project) are often involved in this process.

(b) Approval of establishment of foreign invested enterprises (the "FIE") by the Ministry of Commerce (the "MOFCOM")

MOFCOM is responsible for examining and approving the establishment of FIEs, including the form of their constitutional documents and the approved areas in which they will be permitted to conduct business. 

(c) Special Industry Approvals

Although the main approving authorities are the NDRC and MOFCOM, other authorities may also be involved in approving procedures particularly where there is some limitation on the entrance by foreign investors into a special industry.  For example, the pre-approval from the State Food and Drug Administration ("SFDA") or its branches is needed if the investment involves the pharmaceutical production.

(d) Registration with the State Administration for Industry and Commerce (the "SAIC")

All business entities need to maintain records of corporate documents with local branches of SAIC including basic information regarding registered capital, directors, shareholders and the constitutional documents.  SAIC also oversees initial approvals for special industries such as advertising.

(e) Other business administrations relevant to foreign investors

The tax bureau, the administration of foreign exchange, the finance bureau, the customs and the administration of quality supervision, among others, are all involved in the routine management of FIEs.

1.4 Constitutional Protection

A number of constitutional changes have occurred in recent years.  Businessmen have been allowed to join the CCP since November 2002 which is indicative of the importance now placed on the private sector in modern China.  The amendment to the state constitution in March 2004 and enactment of the PRC Property Law in 2007 both demonstrated the PRC government's commitment to the protection of property rights and investors' interests.  Measures such as these have also helped to strengthen foreign investors' long term confidence in China.

2  Legal System

Shortly after its founding in 1949, the PRC government dismantled the former legal system and created a socialist legal system. The modern Chinese legal system mainly consists of seven (7) branches and four (4) levels of law.  The seven (7) branches of law are: the Constitution and laws related to the Constitution; civil and commercial laws; administrative laws; economic laws; social laws; criminal laws; and litigation and non-litigation procedural laws.  The four (4) levels of law are: the Constitution; laws; administrative regulations; local regulations, and autonomous regulations, specific rules and rules.

Amendments to the Constitution are rectified by a two-thirds majority vote from all deputies of the NPC.

Laws on the following matters are enacted exclusively by the NPC and its Standing Committee: state sovereignty; the formation, organization, functions and powers of state organs; the system of regional autonomy by ethnic minorities, the system of special administrative regions and the system of autonomy at the grass-root level; criminal offences and punishment; the deprivation of citizens' political rights and mandatory measures and penalties involving the restriction of personal freedom; the expropriation of non State-owned property; the basic civil system; the basic economic system and basic systems of finance, taxation, customs, banking and foreign trade; the litigation and arbitration systems and other matters for which laws must be enacted by the NPC or its Standing Committee.  The Standing Committee of the NPC follows the "system of three deliberations" in the enactment of laws, which means that a bill should be deliberated at three (3) meetings of the Standing Committee of the NPC before it is voted on.  An important or controversial bill may undergo more than three (3) deliberations.

The State Council enacts administrative regulations in accordance with the Constitution and the laws.

The people's congresses of the provinces, autonomous regions and municipalities directly under the central government, or their standing committees, have the power to enact local regulations.  The people's congresses of the ethnic autonomous regions have the power to enact autonomous region regulations and also other specific regulations based on local political, economic and cultural conditions.

Ministries and commissions of the State Council and other organs endowed with administrative functions directly under the State Council, such as MOFCOM, SAIC and the China Securities Regulatory Commission (the "CSRC") may, in accordance with the laws and administrative regulations, enact departmental rules within the limits of their power.  The people's governments of the provinces, autonomous regions, municipalities directly under the central government and larger cities may, in accordance with the laws, administrative regulations and local regulations of their respective province, autonomous region or municipality, enact local rules.

Bills are usually deliberated on a non-public basis.  The process is not published in government publications, nor are the bills announced to the public.  However, in recent years, laws, regulations and rules that are controversial or will have a significant social and economic impact on Chinese society, such as the PRC Property Law, the PRC Labor Contract Law, the PRC Food Safety Law and the Administrative Regulations on the Registration of Resident Representative Offices of Foreign Enterprises, have been released on the Internet to solicit public opinion.  Public seminars and public hearings have also been held, for example, in respect of revisions proposed for the PRC Individual Income Tax Law and the PRC Intangible Cultural Heritage Law, as well as the formulation of the Regulations on the Expropriation of Houses on State-owned Land and Compensation.  These signify a major change in the PRC legislative system.

In general, legislative bodies are entitled to construe and interpret the laws and regulations that they have enacted, although such laws and regulations are also subject to the construction and interpretation by other legislative bodies of a higher level.  The PRC body of laws has undergone a comprehensive overhaul since 1979 with the passage and revision of many major pieces of legislation, including laws and regulations applicable to foreign investment.

3  Establishing a Business Vehicle in China

3.1 General Policy

Provisions on Guiding the Orientation of Foreign Investment promulgated by the State of Council came effective on 11 February 2002, which classifies foreign investment areas into four (4) different sectors, the encouraged, permitted, restricted and prohibited.  In the Catalogue of Industries for Guiding Foreign Investment (the "Catalogue") jointly published by the MOFCOM and NDRC further specifies which areas are prohibited, restricted and encouraged for foreign investors, and those areas which are not provided in the Catalogue should be permitted for foreign investors.  According to the Catalogue, we understand the prohibited are areas which cannot be invested by foreign investors, the restricted may have some investment requirements or limitations such as only permitting cooperation jointly by Chinese and foreign investors, or only permitting foreign investor to hold minority interests of the proposed company (or other kinds of organizations) up to 49% etc., and the permitted and encouraged are areas which permit the structure wholly invested by foreign investors.

3.2 Types of Foreign Investment Vehicles

Companies that desire a permanent presence have to set up operations as an appropriate legal entity, depending on the intended business scope, and be compliant with Chinese legal and tax requirements.  The most common legal structures used for establishing a presence in the PRC are:

•  A Representative Office (the "RO")
•  A Wholly Foreign-owned Enterprise (the "WFOE")
•  An Equity Joint Venture (the "EJV")
•  A Contractual Joint Venture (the "CJV")
•  A Foreign-invested Partnership Enterprise (the "FIPE")

Each of these structures has unique advantages, restrictions and drawbacks, and it is essential to choose the option best suited to your business aims.  Among of the above forms, the WFOE, EJV, CJV and FIPE are collectively referred to as FIEs.

(a) RO

ROs are often the first step taken by foreign companies when establishing a permanent presence in China.  ROs can undertake market investigation, display, publicity activities in connection with the products or services of foreign companies, and liaison activities in connection with the products sales, services provision, domestic procurement and domestic investment of foreign companies.  However, ROs are not permitted to engage in any profit activity which means that they cannot sign contracts, receive income, or issue invoices and business tax receipts.  Under PRC law, an RO is considered to be an extension of its establishing company, and does not have the status of a legal person.

To establish an RO in China is relatively easy.  Generally, a foreign company only needs to register with the SAIC to establish an RO.  Law firms, financial and insurance companies and other certain industries may require substantive approvals, but for most industries no substantive government approval is required.  In addition, ROs are not subject to the capital contribution requirement imposed on companies and their investors.

(b) WFOE

A WFOE refers to a company incorporated in China with limited liability that is owned by one or more foreign investors.  Where permitted, a WFOE is now a popular option for foreign business, as the investor may completely control over their business entity as well as enjoy the full profit from its operation.  Moreover, WFOEs also provide a better protection to the investor's intellectual property rights in comparison to other types of entities.

The WFOE is an appropriate structure for companies whose main activities in China are to manufacture and sell products, or provide services such as research and development or business consultancy.  A WFOE allows the foreign investor to issue invoices and receive revenues in Renminbi (the "RMB") that can then be converted and repatriated out of China.

Compared to an RO, to establish a WFOE is a little more complex and time consuming, since generally the WFOE has to get the approval from MOFCOM prior to registration with SAIC.  In addition, besides the approval from MOFCOM, the WFOE usually should obtain approvals from other governmental authorities such as NDRC and SFDA etc., depending on the WFOE's business scope.

(c) EJV

An EJV is typically used for long-term projects and is formed by foreign companies, enterprises, other economic organizations or individuals and Chinese companies, enterprises or other economic organizations.  An EJV is typically a limited liability company.  The proportion of an EJV's registered capital contributed by the foreign investors shall not be less than 25%.

The board of directors is the highest authority of an EJV, which should decide all major issues concerning the EJV.  An EJV must have at least three (3) directors, including a chairman and a vice chairman.

For foreign investors who are not familiar with Chinese market, an EJV may be beneficial for such foreign investors.  A good local partner may contribute market knowledge and strong marketing and distribution channels, and they may help reduce the costs and risk of market entry.  In certain restricted sectors, such as automotive and insurance, forming an EJV with a Chinese company is still the only permitted route for establishing a permanent presence in China.

The challenge of establishing and running a successful EJV is finding and nurturing the right partnership.  Partners have to overcome issues such as mismatched expectations and differences in business culture and practices.  The ability to maintain effective communication, and control where necessary, is also crucial.

(d) CJV

A CJV is often adopted for shorter-term projects or built-operate-transfer projects, and are formed with join capital or terms of cooperation between foreign enterprises, other economic organizations or individuals and Chinese enterprises or other economic organizations.  CJV can be registered as a limited liability company which owns the status of legal person, but it is not mandatory.  A CJV should set up a board of directors (a CJV which has the status of legal person) or a joint management committee (a CJV which has no status of legal person) which is the authority of CJV.

CJVs are similar in many ways to EJVs but have the potential to be more flexible in certain aspects.  Unlike EJVs, the profits, risks and losses of CJVs may be allocated between the parties in a proportion that differs from the equity contributions by the parties.  It may also be possible for the foreign investor to recover its investment before the end of cooperation term of the CJV.

(e) FIPE

On 1 March 2010, Administrative Measures on the Establishment of Partnership Enterprises in China by Foreign Enterprises or Individuals came into effect, allowing foreign individuals or organizations to participate in partnership enterprises, offering a further alternative to the RO, WFOE, EJV and CJV.  FIPEs allow for partnerships between two or more foreign enterprises or individuals, or a combination of foreign enterprises or individuals and Chinese individuals, legal persons or other organizations.

FIPEs do not need to obtain the approval from MOFCOM.  They only require registration through the local branches of SAIC.  However, businesses in certain sectors will need to comply with other specific regulations and the FIPE should submit approvals from relevant authorities when applying for its registration.

The types of FIPEs include foreign-invested general partnership and foreign-invested limited partnership.  Solely State-owned companies, State-owned enterprises, listed companies and public welfare institutions and social organizations shall not be general partners of FIPEs.  Limited partners cannot be the executive partner of a FIPE.

The FIPE provides a good channel to enter into Chinese market for foreign investors, especially for those private equity firms.

(f) Branch Office

Besides the above forms, a foreign company can set up a branch office in China if certain prerequisites, which may vary for different industries, can be met.  Such branch office does not have independent legal person status and its parent company will be held liable for all of its business activities in China.  Generally, in practice not all industries are permitted to establish a branch office by the foreign company in China.

The approval authority for the establishment of branch offices is generally MOFCOM or its local counterparts, while for certain regulated industries, it is the industry administration authority, such as China Insurance Regulatory Commission ("CIRC") or China Banking Regulatory Commission ("CBRC") that is charged with the approval responsibility.  Following the obtaining of approval of establishment, a branch office must apply to the local branch of SAIC for a business license.

3.3 Investment Process

(a) Establish a New Company

As analysis in Item 3.2, there are several different choices for foreign investors if they want to establish a new company in China.  Foreign investors may select a proper vehicle in accordance with their business considerations.

(b) Merger and Acquisition (the "M&A") of Domestic Chinese Enterprises

(i) General rules

Instead of setting up a brand new company, a foreign investor may acquire the equity interest in or the assets of a domestic Chinese company, assuming that such domestic company is engaged in an industry which is open to foreign investment under the Catalogue, and the shareholding ratio of foreign investors is compliant with the relevant rules and regulations.  There are two ways of achieving this, namely: ⑴ by establishing a FIE with the purpose of using such FIE to purchase assets from a PRC domestic company, or by directly acquiring assets from a PRC domestic company and then using those assets to establish a FIE; and ⑵ by acquiring the equity interest in, or by subscribing for new equity in a PRC domestic company, resulting in the conversion of such PRC domestic company to a FIE.

(ii) Special provisions on State-owned Enterprises

If the subject matter of the M&A involves the equity interest or assets of a State-owned enterprise (the "SOE"), a qualified asset valuation company must be appointed to carry out a valuation of the State-owned equity interest or assets in question.  The valuation result must be approved by or filed with the appropriate level of the State-owned Assets Supervision and Administration Commission of the State Council (the "SASAC"), and will be used as a reference for the determination of the transfer price of the State-owned equity interest or assets.  Where the agreed transfer price falls below 90% of the valuation, approval from the relevant property rights transfer government authorities must be obtained before the transaction may continue.  Moreover, the sale of State-owned equity interest or assets to foreign investors must be conducted publicly through holding public tender, or by listing or being auctioned on a recognized property rights exchange.

(iii) M&A  procedures

When acquiring the equity interest in or assets of an existing domestic company, it is necessary to conduct a thorough due diligence investigation on the Chinese target company or the assets to be acquired.  It is important to confirm that the target company was duly organized and are validly existing, and to investigate any loans borrowed or extended, and the title of any assets (including but not limited to land use rights, intellectual property rights etc.) owned by the target company.  The results of such thorough due diligence can provide guidance to the foreign investor when negotiating the contractual terms of the acquisition.

As the completed M&A will result in the conversion of the domestic company into an FIE, it is essential to obtain approval from the government authorities at the correct level.

If the proposed M&A by foreign investors of a domestic company satisfies the reporting standards as stipulated in the Rules on Standards of Reporting Business Operator Concentration promulgated by the State Council, the foreign investors shall report to the MOFCOM beforehand, and no transaction shall be conducted without reporting.

In 2011, the State Council released certain rules on the national security review.  Where the target domestic enterprise is involved in a business that concerns national defense security issues or national economic security issues, the national security review process will be conducted by the Joint Committee led by NDRC and MOFCOM.  If the proposed transaction is determined by the Joint Committee that it has or is likely to have a major impact on national security, the merging parties will be required to terminate the transaction or to undertake certain remedies such as the transfer of relevant shares, assets to eliminate any impact on national security.  It's worth noting that the variable interest entities mode (the "VIE") which was common used in foreign investments will face restrictions for certain industries in the future.

Following the obtaining of governmental approvals, registration with the local branches of SAIC and other relevant governmental authorities, such as tax administration authority, customs administration authority and foreign exchange administration authority, will have to be conducted within specified time periods.

(c) M&A of FIEs

Alternatively, a foreign investor may acquire the equity interests of a FIE held by another foreign investor.  Acquiring the equity interests in an already established FIE requires the consent of all other original shareholders, approval by the government authorities which initially approved the establishment of the FIE, and re-registration with SAIC.  In the case of an EJV, unanimous approval of the EJV's board, or in the case of some CJVs, the "joint management committee", is also required.

(d) Merger and Division of FIEs

Merger and division of FIEs are allowed in the PRC.  The merger of two or more FIEs requires approval from the relevant PRC government authorities that originally approved the establishment of each of those FIEs.  Similarly, the division of a FIE requires approval from its original examination and approval authority.

(e) Purchasing Shares in PRC Public Companies

Shares in PRC companies listed on the Shenzhen or Shanghai stock exchanges are classified into "A" shares, which can only be sold to Chinese citizens and organizations, Qualified Foreign Institutional Investors (the "QFII") and strategic foreign investors, and B shares, which can be sold to foreign citizens and organizations, including persons from Hong Kong, Macau and Taiwan, and (since February 2001) also to Chinese nationals residing inside the PRC.

3.4 Government Approval

(a) Approval Level

According to PRC law, the foreign invested projects should be submitted to NDRC or its local branches for the project review (if necessary) and the contract and articles of association (the "AOA") should be submitted to MOFCOM or its local branches prior to registration with SAIC.  The following chart shows which level of government approvals should be obtained.

Moreover, for the approval of an investment company by MOFCOM, if its registered capital is less than USD300 million, the approval level should be provisional or local MOFCOM, and only if its registered capital is or exceeds USD300 million it should obtain the approval from central MOFCOM.

(b) The Basic Approval Process

An FIE may be established only with the approval of the Chinese government.  The approval process for forming new entities or for acquiring existing companies (thereby converting them into FIEs) is largely the same.  The approval process begins with a name reservation application to the SAIC to check on the proposed name for the FIE.

After the company name has been reserved, the applicant must obtain substantive examination and approval of the investment by MOFCOM.  Examination and approval by MOFCOM is the key stage in the approval process.  It requires submission of the full definitive documents for the proposed FIE to MOFCOM, and may also require a feasibility study report describing background on the project, along with other supporting documents.  MOFCOM has the flexibility to request documents not expressly set forth in the statutes if they believe such documents would be helpful to its decision.

Project Verification from NDRC is technically required for any foreign investment project, but in practice, the NDRC's approval is critical only in certain industries, such as automotive industry, oil exploitation industry, etc.

After approvals from MOFCOM and NDRC (if necessary), the FIE may be registered with SAIC for issuance of a business license.  Under PRC law, the date of issuance of the business license is the date of incorporation of a company.  After obtaining the business license, the FIE should complete remaining registrations with relevant authorities including branches of State Administration of Foreign Exchange (the "SAFE"), General Administration of Customs of the People's Republic of China (the "Customs") and State Administration of Taxation ("SAT"), etc.

(c) Special Approvals

For some certain industries, the FIE should obtain special approvals.

Environmental approval from State Environmental Protection Agency (the "SEPA") may be required prior to applying to MOFCOM for manufacturing enterprises, or for any investment project that entails a construction project.  Before registration with SAIC, for companies involving food or pharmaceutical production, they have to get the approval from SFDA.

The approval from SASAC will be required for investments involving Stated-owned assets.
Some typically regulated industries (including, for example, securities, banking and insurance) involve special approval regimes in addition to, or in place of, MOFCOM examination and approval.  CSRC reviews applications to set up or acquire securities companies, CBRC covers banks, and CIRC reviews insurance company applications.

4  Operating in China

Whereas the previous parts addressed the basic political and legal system of China and the entry into Chinese market, this part will outline the principle business and commercial regulations governing the operations of FIEs in China.

4.1 Taxation

(a) Tax System

Under the current tax system, the PRC imposes about twenty (20) types of taxes, including enterprise income tax (the "EIT"), value added tax (the "VAT"), business tax, property tax, consumption tax, land appreciation tax (the "LAT"), land use tax, deed tax, stamp duty and individual income tax (the "IIT").  PRC has signed income tax treaties and arrangements with more than 80 countries and regions, including two special administrative regions of the PRC, Hong Kong and Macau.

(b) EIT

On 1 January 2008, the new unified PRC Enterprise Income Tax Law (the "EIT Law") became effective.  It consolidated the previous two separate income tax regimes for domestic enterprises and FIEs into one single income tax regime. The new EIT Law introduced the concept of resident enterprises, unified the tax rate for Chinese domestic enterprises and FIEs, replaced the old tax incentive system with a new model and addressed special tax adjustments, such as adjustments made pursuant to transfer pricing, or thin capitalization rules.

(i) Resident Enterprises vs. Non-resident Enterprises

A resident enterprise refers to an enterprise which is legally established in accordance with PRC law, or an enterprise which is legally established in a foreign country or region whose actual administration institution is in China.  The actual administration institution refers to the institution that actually and comprehensively manages and controls the production and operation, staff, account, property and other aspects of the enterprises.  A resident enterprise should pay EIT on its worldwide income, i.e., income derived from sources both inside and outside the PRC.

A non-resident enterprise refers to an enterprise which is legally established in a foreign country or region whose actual administration institution is outside China, but which either has an establishment in the PRC or has no establishment in the PRC but derives PRC-sourced income.  A non-resident enterprise which has an establishment or place in the PRC pays EIT on income which is derived from sources inside the PRC, as well as on income which, although derived from sources outside the PRC, is effectively connected with such establishment.  If a non-resident enterprise has no establishment in the PRC, or has an establishment in the PRC but has derived income not effectively connected with such establishment, it pays EIT only on income derived from sources inside the PRC.

(ii) Tax Base and Tax Rate

The taxable income of an enterprise is defined as the amount remaining from its gross income in a year, after non-taxable income, tax-exempt income, various expenses and losses have been deducted.  Losses incurred by an enterprise may be carried forward for a period of five (5) years.  No carry-back is permitted.  Reasonable expenditures which have actually been incurred and are related to the generation of income, including costs, expenses, taxes, losses and other expenditures are deductible.

A PRC resident enterprise is subject to EIT at a rate of 25% on its worldwide income.  A non-resident enterprise having an establishment in the PRC is subject to EIT at a rate of 25% on its PRC-sourced income received by the establishment as well as its non-PRC-sourced income actually connected with the establishment.  Where a non-resident enterprises that does not set up an institutions or establishments in China, or where institutions or establishments are set up but there is no actual relationship between the income and such institutions or establishments, the non-resident enterprise should pay EIT at a rate of 10% in relation to the income originating from China, which should be subject to tax withholding at source with the payer as the withholding agent.  Under certain tax treaties between China and other countries and/or regions, non-resident enterprise may enjoy more preferential tax treatment depending on the provisions of such treaties.

(iii) Tax Incentives

Various EIT incentives are provided in the EIT Law.  Preferential treatment is generally granted to industries and projects, the development of which is supported and encouraged by the State.

Qualified high-new technology enterprises (the "HNTEs") enjoy a 15% preferential tax rate nationwide.  Further, in respect of HNTEs established in the five special economic zones (Shenzhen, Zhuhai, Xiamen, Shantou and Hainan) and Pudong New Area of Shanghai, a tax holiday of a two-year exemption of EIT and a three-year half reduction of EIT will apply commencing from the first profitable year.

Venture capital investment enterprises enjoy a bonus deduction equaling 70% of the investment made to qualified medium and small sized high-tech enterprises, upon reaching two (2) years of ownership.  A bonus deduction or amortization of 50% of expenses incurred for research and development activities for new technology, new products, or new craftsmanship is also available to most enterprises.

Incomes earned from projects of agriculture, forestry, husbandry and fishery, incomes earned from business operations of important public infrastructure investment projects supported by the state, and incomes earned from eligible projects of environmental protection, energy and water saving may be exempted or reduced.

(c) IIT

China has a progressive IIT ranging from 3% up to 45%.  Generally, an individual who has a domicile in the territory of China or who has no domicile but has stayed in the territory of China for one (1) year or more should pay individual income tax for his/her incomes obtained in and/or outside the territory of China.  An individual who has no domicile and does not stay in the territory of China or who has no domicile but has stayed in the territory of China for less than one (1) year should pay individual income tax for his incomes obtained in the territory of China.

An FIE must generally serve as a withholding agent for its employees, and withhold and pay IIT on their behalf each month.  China relies principally on withholding to collect IIT, and only those individuals whose annual income is RMB120,000 or more, whose income from outside the territory of China, who receive wage and salary income from at least two (2) sources within the territory of China, or who receive taxable income but have no tax withholding agent, are required to file separate annual tax returns to the competent tax authorities.

(d) VAT

VAT is levied on the sale of goods inside the PRC, the import of goods into the PRC and the provision of processing, repair and maintenance services in the PRC.  The standard tax rate for most goods is 17%, though a concessionary rate of 13% applies to certain goods such as agricultural machinery, books and utilities.
The PRC VAT regime distinguishes between general VAT taxpayers and small scale VAT taxpayers.  The threshold to qualifying for general VAT taxpayers are those whose annual sales are above RMB 0.5 million for manufacturing enterprises and above RMB 0.8 million for trading enterprises.  The small VAT taxpayers should pay VAT at a lower rate of 3%.

(e) Business Tax

Business tax is levied on the provision of most services within the PRC, the transfer of intangible property in the PRC and the transfer of real property in the PRC.

Business tax rates

(f) Consumption Tax

Consumption tax is imposed as a measure to monitor the consumption of goods deemed as luxury or unhealthy.  It is charged to any person or unit engaged in the manufacturing, subcontracting, importing or processing of the prescribed goods.  The rate varies, depending on the exact taxable items.

(g) Stamp Duty

Stamp duty is levied on specific documents executed or obtained in the PRC. The rates generally range from 0.01% to 0.003%, depending on the type of document. To the extent that a document is a contract to which there is more than one contracting party, each party needs to pay stamp duty at the full statutory rate.

(h) Deed Tax

Deed tax is levied on the transfer of land use rights and real property.  The rate is 3% to 5%, depending on the location of the land or property.  Deed tax is payable by the transferee.

(i) LAT

LAT is levied on the gain from the transfer of State-owned land use rights and the property situated on the land.  The rates are progressive ranging from 30% to 60%, depending on the percentage of the appreciation.

(j) Property Tax

Property tax is levied on the ownership of real property in urban areas.  It is assessed at an annual rate of 1.2% of the original cost of the building with less a 10% to 30% deduction (this percentage of deduction is determined by the relevant local authorities and thus may vary from location to location) or at a rate of 12% of the annual rental income.  From 1 January 2009, Chinese companies or individuals have stopped paying property tax; however, FIEs, foreign enterprises and organizations and foreign individuals continue to pay property tax.  In early 2011, Chongqing and Shanghai has begun to levy property tax again.

(k) Urban Land Use Tax

Urban land use tax is levied on the ownership of land use rights in urban areas.  The exact rate depends on the location of the relevant land.  According to the national regulations, the applicable rates per square meter are RMB 1.5 to RMB30 per year for large cities, RMB1.2 to RMB24 per year for medium-sized cities, RMB0.9 to RMB18 per year for small cities and RMB 0.6 to RMB12 per year for counties.

(l) Customs Duty

Customs duty is levied on the imported and exported goods and articles entering or leaving the territory of the PRC. Customs duty is payable according to a tariff schedule.  With free trade agreements (the "FTA"), goods traded between the PRC and the FTA signatory countries qualify for lower customs duty rates.  Qualified enterprises enjoy duty reduction or exemption as a tariff preference measure.

4.2 Employment

(a) Regulatory Environment

The foundation for China's employment laws, rules, and regulations is the PRC Labor Law, which was enacted on 1 January 1995 by the NPC.  Another milestone in the development of China's labor and social security legislation is the PRC Labor Contract Law, which was passed by the NPC and came into force on 1 January 2008.  Later, the Regulations of Implementation on the PRC Labor Contract Law became effective on 18 September 2008, which specifies certain issues on labor.

Employment matters, including those of FIEs, within the territory of the PRC are all subject to the PRC Labor Law, the PRC Labor Contract Law, and other laws and regulations issued by the NPC or the central government.  There are also local regulations and rules issued by provincial, municipal, and other lower level government authorities that are only applicable to the relevant local regions.

(b) Contract of Employment

PRC law allows the employer to engage a part-time employee with an oral contract.  However, in case of any employment of full time employee, the parties are required to enter into a written labor contract within one month from the date of commencement of employment.  Failure to comply with this provision results in the employer being required to pay to the employee twice the amount of the agreed remuneration as salary.

(c) Minimum Wage

There is a system of guaranteed minimum wages and salaries for Chinese workers.  Local people's government will formulate its own specific standards for minimum wages and salaries.  The payable wages and salaries (exclusive of any overtime pay, social insurance/housing fund contributions borne by the employee, or any allowance for middle/night shifts, high/low temperature etc.) shall be in no case lower than the local minimum wage and salary standards if the workers have provided "normal work" pursuant to their labor contracts.

(d) Working Day and Overtime

There are three kinds of work hour systems, i.e., standard work hour system, comprehensive work hour system and indefinite work hour system.

(e) Social Insurance

The employer is obliged to have their PRC employees enrolled in the applicable social insurance schemes provided by the local labor authorities, and withhold the contributions borne by the employee (referred to as the "Individual Contributions" below) from his/her monthly salary and pay the individual contributions as well as the contributions borne by the employer (the "Company Contributions") to the local social insurance institution each month.

The rate and contribution basis of social insurance premium depends on the relevant local regulations.  Different localities provides for different categories of social insurance schemes, which mainly depends on the localities of the domicile of the employees.

(f) Health and Safety

Employers are required to strictly implement the rules and standards of the State with regard to occupational safety and health, carry out relevant education among employees, prevent accidents in the process of work, and lessen occupational hazards.  Facilities of occupational safety and health must meet the standards set by the State.

(g) Termination of Employment and Economic Compensation

(i) Termination initiated by employer

The employer is generally not allowed to unilaterally terminate the labor contract at will or without cause.  The termination of employment initiated by the employer is not allowed unless some specific conditions (i.e., the statutory termination grounds) have occurred, for instance, the employee seriously violates work rules and regulations of the employer.

If the employer terminates the employment of the employee in violation of law, the employee may request for specific performance, i.e., reinstatement to his/her job position.  If the employee does not so request or the contract is no longer capable of being performed, the employer shall pay twice the usual severance pay amount as damages to the employee.

(ii) Termination by mutual consent

If the employer proposes to terminate the employment of the employee, and the employee so agrees after negotiation between the parties, the labor contract can be terminated, which is referred to as the "termination by mutual consent" in the PRC employment law.

(iii) Termination initiated by employee

The employee may: ⑴ unilaterally early terminate the labor contract without cause as long as he/she gives a 30-day prior written notice to the employer (in case such employee is in probationary period, such prior notice period is three (3) days); or ⑵ immediately terminate his/her labor contract without any prior notice under some specific circumstances, such as when the employer does not pay the employee in full and on time.

(h) Labor Secondment or Contractual Worker

The ROs set up by foreign companies are not allowed to employ staff directly in the PRC but may only obtain the staff through certain designated labor agencies (the "Agency") like Foreign Enterprise Services Corporation (the "FESCO"), which is generally referred to in China as the labor secondment arrangement.  Local labor bureau are in charge of monitoring compliance.  Under this arrangement, the RO as the Secondee Company signs a service contract with the Agency for engagement of their labor secondment services, and the employee as the Seconded Employee, who may be appointed by the Secondee Company or the Agency, signs labor contract with the Agency and is seconded to work in the Secondee Company.

(i) Employment of Foreigners

In most cases, employers must recruit Chinese nationals if at all possible.  In order to bring in a foreign employee, the employer must first apply to the local labor bureau for an employment permission certificate to bring in the intended employee.  Once the employer has received the employment permission certificate, the foreign employee must apply for a work visa at his local Chinese consulate.  After entering China, the employee must obtain a work permit and residence card prior to commencing employment.  Foreign experts, off shore petroleum workers, cultural and artistic performers, and representatives of ROs enter China under different procedures.

4.3 Antitrust & Competition

(a) Legislation

A broad range of PRC laws contain one or more provisions prohibiting anti-competitive practices such as price-fixing, market-sharing and below-cost sales. These include the Anti-Unfair Competition Law and the Price Law.  Many of these provisions have not been widely enforced, and the fragmented structure of the competition legislation reflects the historical absence of a cohesive competition policy in the PRC.

However, a comprehensive Anti-Monopoly Law (the "AML") came into effect on 1 August 2008.  A number of provisions in the AML overlap with pre-existing competition provisions, but it is expected that the AML will be the primary law used to tackle anti-competitive conduct going forward.  The AML regulates three (3) main areas of business conduct: monopoly agreements, the abuse of a dominant market position, and concentrations (i.e., M&A deals and certain other transactions) with anti-competitive impacts.  These prohibitions are understood to apply to nearly all businesses, although SOEs may receive some special treatment under the AML, and certain activities of agricultural producers and farming entities are exempt from the law.

(b) The Development Nature of the PRC Competition Regime

Prior to the commencement of the AML, most PRC competition-related provisions were rarely enforced.  The main exception was the merger control regime under the M&A regulations.  However, the commencement of the AML, and the introduction of significant new legal liabilities relating to anti-competitive practices, reflects an increasing focus on competition issues in China.  This suggests that, going forward, competition provisions may be enforced with more vigor than historically has been the case – particularly once further detailed implementing regulations and guidelines regarding application and enforcement of the AML are released.

It should also be noted that many of the laws prior to the AML that incorporate competition-related provisions remain in force.  While many of these provisions overlap with the AML, in some cases they may have a potentially broader application.  Additionally, some competition provisions are sector-specific, relating to industries such as banking and telecommunications.  It is possible these provisions may still be applied going forward, either in conjunction with the AML or on a stand-alone basis.

4.4 Intellectual Property

Intellectual property protection is a key consideration for foreign investors entering Chinese market.  The PRC has a comprehensive regime of intellectual property laws which provide a wide range of remedies and channels for enforcement, including civil and criminal courts, several different administrative enforcement authorities, prosecutors and polices.  Legislation facilitating private prosecution by intellectual property owners came into effect in 1997.  These intellectual property laws are compliant with the requirements under the Agreement on Trade-Related Aspects of Intellectual Property Rights (the "TRIPs Agreement") of the World Trade Organization.  Also, China is a party to most of the international conventions on intellectual property rights, including:

•  the Paris Convention for the Protection of Intellectual Property Rights
•  the TRIPs Agreement
•  the Berne Convention for the Protection of Literary and Artistic Works
•  the Universal Copyright Convention
•  the WIPO Copyright Treaty
•  the Locarno Agreement for International Classification for Industrial Designs
•  the Madrid Agreement for the International Registration of Trademarks
•  the Nice Agreement for the International Classification of Goods & Services
•  the Patent Co-operation Treaty
•  the Strasbourg Agreement for International Patent Classification
•  the Budapest Treaty for Deposit of Micro-organisms
•  the Geneva Convention on Unauthorized Duplication of Phonograms
•  the WIPO Performances and Phonograms Treaty

Although the laws are there, the level of infringement and the inadequacy of enforcement has been the subject of disputes with Chinese trade partners, particularly the United States of America.
In China, PRC law provides protection for the patent, trademark and copyright.

(a) Patent

There are three (3) types of patents in China: invention patents, utility model patents and design patents.   Invention refers to any new technical solution relating to a product, a process or improvement thereof.  Utility model refers to any new technical solution relating to the shape, the structure, or their combination, of a product, which is fit for practical use.  Design refers to any new design of the shape, pattern or their combination and the combination of color and shape or pattern, of a product, which creates an aesthetic feeling and is fit for industrial application.

Patents may be assigned or licensed, but only upon registration with the State Intellectual Property Office of the People's Public of China (the "SIPO").  Invention patents are the most robust of the three (3) kinds of patents, involving a meticulous review process that takes several years to complete, and providing protection for a period of twenty (20) years from the date of filing to SIPO.  Utility model patents and design patents have a less meticulous and lengthy review process, and also provide a shorter period of ten (10) years after the date of filing.  China's patent system works on a first to file basis.

(b) Trademark

In China, trademarks include registered trademarks and unregistered trademarks.  Only if trademarks are registered with the Trademark Office of the State Administration for Industry and Commerce of the People's Republic of China (the "Trademark Office") can such trademarks seek protection under the PRC Trademark Law, unless the unregistered trademarks are be defined as well-known trademarks.  The period of validity of a registered trademark is ten years commencing from the date of approval for the registration, with subsequent ten-year extensions being available.  Registered trademarks may be assigned or licensed provided such assignments or licenses are registered with or approved by the Trademark Office.

(c) Copyright

The PRC Copyright Law provides protections for creative works, including software.  The National Copyright Administration of the People's Republic of China (the "NCAC") oversees the copyright system.  The NCAC oversees a non-mandatory registration process covering the both registration of copyrights themselves and of assignments or licenses thereof.

4.5 Real Property

(a) Overview

In China land in urban areas shall be owned by the State, and land in rural and suburban areas, unless otherwise prescribed by the State, shall be collectively owned by farmers, including land for houses and private plots in fields and on hillsides.  Neither domestic companies nor FIEs can own land, although they may hold land use rights.

For State-owned land use rights, there are two (2) different types, allocated land use rights and granted use rights.  Generally, the State-owned land use right shall be obtained by paid means such as grant.  However, upon the approval from the government at or above the county level, the State-owned land may be allocated for government institutions or the military; urban infrastructure or public welfare projects; or energy, transportation and water conservancy projects as well as other infrastructure projects supported by the government.  In general, allocated land use rights cannot be transferred or leased without first being converted into granted land use rights (for which a grant fee must generally be paid to the government).  The government may reclaim allocated land use rights at any time without compensation. 

Granted land use right is the right to use land for a specific purpose for a fixed term, seventy (70) years, fifty (50) years or forty (40) years, depending on the purpose of land.  A grant fee must be paid to the government for granted land use rights.

Buildings on land generally should be owned by the same person that holds the corresponding land use rights.  Nevertheless, land use rights and buildings on the corresponding land are sometimes owned by different persons.

(b) Land use rights transfers

Under PRC law, only granted land use rights may be transferred.  Nobody will obtain title to allocated land, even if someone purports to sell it to you, provided that it is first converted to granted land use rights (for which a grant fee must first be paid to the government).  Vacant land is required to be at least 25% developed before the corresponding land use rights can be transferred.  The government may reclaim vacant land if development is not started within two (2) years of transfer.

(c) Renewal of land use rights

From 1 October 2007, the term of residential land use rights will be automatically renewed upon expiry.  This is a welcome relief to those owning residential properties in China.  It will also ensure that financing remains available for residential property approaching expiration of its land use right term.  Non-residential land use right terms are not granted automatic renewal under the Property Law.  Rather, renewal will be subject to other laws and regulations.

(d) Easements

The creation of easements has been recognized since the PRC Property Law became effective on 1 October 2007.  The ability to create easements recognized by law is likely to be of particular importance for infrastructure projects that involve the construction of pipelines or other networks requiring access to land over which the project owner does not hold the land use rights.

(e) Leasing

Land must generally have been developed before it can be leased.  A lessee is required to comply with the terms and conditions of the land use rights grant contract.  A registered lease with authorities will gain priority over any unregistered lease.

(f) Expropriations

Land may be expropriated by the government only in special circumstances and in the public interest.  Compensation is required to be paid if land is expropriated.

4.6 Foreign Exchange

China's currency, the RMB, is not fully convertible.  The RMB is ultimately monitored and controlled by China's State Administration of Foreign Exchange (the "SAFE").  In the past, all foreign currency transactions involving the purchase or sale of RMB were subject to SAFE's review and approval.  Since China became a member of the WTO in 2001, China's foreign currency policy has become increasingly less restrictive.

Under PRC law, foreign currency transactions are categorized as the capital account transactions and the current account transactions.  Capital account transactions refer to the transaction items in the balance of payments leading to changes in external assets and liabilities, including capital transfers, direct investments, portfolio investments, derivatives, loans, etc.  Current account transactions refer to the transaction items in the balance of payments involving goods, services, income, and current transfers, etc.  Compared to payments of capital, current account items may face relatively easier control.

An FIE may, subject to SAFE approval, open a foreign exchange account with a designated foreign exchange bank.  Usually, the account must be opened within the same area in which the FIE is registered.  The approval is required to open an account in another area.  An FIE may purchase foreign exchange if it has insufficient funds in its foreign exchange account to meet a foreign exchange obligation.  Foreign currency accounts of FIEs are subject to annual inspections by SAFE.  Moreover, foreign investors without an FIE in China may open a multicurrency account with a bank to fund the pre-establishment expenses of an FIE.

4.7 Environmental Regulation

The PRC Environmental Protection Law is the national law governing all environmental protection matters in the PRC.  In addition to the Environmental Protection Law, other laws and regulations such as the Prevention of Atmospheric Pollution Law and the Prevention of Water Pollution Law have been enacted to regulate different parts of the environment.  Different provinces and municipalities have also implemented their own environmental protection regulations which are of regional application.

It should be noted that the PRC government has not separately formulated a set of rules and regulations concerning environmental protection for FIEs and FIEs within the territory of the PRC are subject to the same regulatory regime as domestic enterprises.

It's also worth noting that China's recent green policy link benefits in other areas to environmental compliance.  Green insurance policies require enterprises in certain sectors to insure against environmental damage.  Green trade policies may result in higher export taxes on products made in pollution-intensive industries.  The EIL Law also contemplates green taxation polices, providing tax incentives and sanctions concerning the environment.

4.8 Product Safety

China does not have a single, codified product safety law.  Manufacturers and sellers of products and other stakeholders in this area must follow legal requirements as set out in various laws and regulations, including the General Principles of the Civil Law, the Law on Protection of the Rights and Interests of Consumers, the Criminal Law, and laws on the Administration of Pharmaceuticals and on Product Quality.  China issued important legislation on food and product safety in the past several years, including the Law on the Quality and Safety of Agricultural Products in 2006; several sector-specific regulations covering the recall of vehicles, toys, food, and drugs in 2007; and the Food Safety Law and its implementing rules in 2009, which represented a milestone in the formation of China's product safety regime.  These laws and regulations responded to the public's rising concern about product safety in China.  Despite these laws and regulations, China has experienced a number of significant product safety issues in the recent years.

4.9 Dispute Resolution

As an increasing number of foreign investors penetrate the Chinese market, commercial disputes are expanding quickly both in number and in scale.  China has made significant progress in increasing the integrity and reliability of its courts.  The formal processes available for resolving such disputes in China have, in recent years, become increasingly similar to those elsewhere in the world.

If a dispute cannot be settled through negotiation between the parties, the case must be submitted for litigation or arbitration.  Under PRC law, it is permitted for the parties to choose for binding arbitration to resolve their disputes and the courts will generally enforce arbitration judgment without inquiry into the merits.  It is worthy noting that arbitration is only possible if the parties expressly agree to arbitrate. In practice, the arbitration is favored by many foreign investors in China.

(a) Litigation

The PRC courts consist of four (4) layers: the People's Court (at the district or county level), the Intermediate People's Courts (at the municipal level), the High People's Courts (at provincial level), and the Supreme People's Court (at the national level).  The level of the competent court should be generally subject to the nature and size of the disputes.  In most cases, disputes with a foreign connection may be initially in the Intermediate People's Courts.

Court judgments may be appealed once, but the judgment of the second instance is final and binding upon the parties immediately.  Under the PRC Contract Law, it is permitted to select a foreign law to govern the contract with a foreign connection and to provide for exclusive jurisdiction in foreign courts.  In fact, it may be difficult for Chinese courts to enforce a judgment made by a foreign court, but Hong Kong's judgments are exceptions.

(b) Arbitration

In comparison to litigation, the arbitration seems much quicker, more efficient and more reliable, thus major foreign investors would like to include an exclusive arbitration clause in their contracts.

 Under PRC law, an express clause clearly indicating the parties' selection of binding arbitration is enforceable, which should be in writing and contain a clear statement of the parties' intention to submit the dispute to arbitration, the scope of disputes subject to arbitration, and the specific arbitral commission to resolve the dispute.  In addition, it is possible for the parties to reach an arbitration agreement after a dispute arises, but in most cases an arbitration clause is included from the outset in the operative contracts.

The China International Economic and Trade Arbitration Commission (the "CIETAC") is one of the most frequently selected arbitration forums when the arbitration will be held within the PRC.  Foreign investors sometimes do not agree to arbitration in PRC, including arbitration at CIETAC, because they believe that Chinese parties will have a home advantage, meanwhile, Chinese parties concomitantly often object to arbitration aboard.  Therefore, Hong Kong seems as acceptable compromise to both parties.  Of course, to select a third country's jurisdiction for arbitration is also common in practice.  Since China is a party to the United Nations Convention of Recognition and Enforcement of Foreign Arbitral Awards, it is generally possible to obtain the enforcement of an arbitration award issued by a panel in any member country.

a) Increased Deemed Profit Rate

According to the Rep Office Tax Measures, there are only two ways to tax Rep Offices, the Actual Profit Method or the Deemed Profit Method.

The Actual Profit Method is subject to the ability of the Rep Office to properly record its operations in its financial accounting books and accurately calculate its taxable income and profit through proper reflection of the actual functions it performs and risks assumed and then report returns based on such records to the tax authorities on a quarterly basis.

The Actual Profit Method of Rep Office taxation is advantageous because, unlike the Deemed Profit Method, costs can be used to reduce taxable profits. However, if a Rep Office is unable to maintain complete accounting books, or cannot accurately calculate its returns or costs, the Rep Office will be taxed according to the Deemed Profit Method, which is based on the Rep Office’s costs or revenue. The selection will depend upon which amount can be more accurately illustrated by the Rep Office. The tax authority will designate a deemed profit rate to the Rep Office and calculate the taxable income based on such deemed profit rate.

By the Rep Office Tax Measures, the minimum deemed profit rate under the Deemed Profit Method was increased from 10 to 15 percent. It should be noted that the Rep Office Tax Measures only provide a minimum deemed profit rate so there is a chance that some local tax bureaus may decide to impose a higher rate.

b) Abolishment of Tax Exemption

The Rep Office Tax Measures repeals several previous tax regulations applicable to Rep Offices and therefore Tax Exemptions for Rep Offices have also been abolished.

In the past tax regulations previously applicable to Rep Offices include 1) regulations pertaining to a Rep Office's non-taxable activities, such as market research and information collection, 2) regulations providing for income tax exemptions for Rep Offices established by foreign governments and non-profit organizations, and 3) the specific rules relating to the classification of Rep Offices under the Actual Profit Method and Deemed Profit Method. As an alternative for the abolished tax exemptions, the Rep Office Tax Measures provide that a Rep Office at its own initiative can apply for such special tax treatment which may be applicable to the Rep Office according to tax treaties or agreements.

c) Liability for Rep Offices to pay Value-Added Tax (VAT)

The Rep Office Tax Measures also provide that, in addition to income tax and business tax, Rep Offices should also pay VAT, which generally applies to sales of goods. This new requirement is  ambiguous in that Rep Offices are prohibited from directly engaging in the sale of goods.
Regarding the administrative restrictions on Rep Offices, the State Administration for Industry and Commerce (SAIC) and the Ministry of Public Security jointly issued the “Notice Concerning Further Strengthening Administration of the Registration of Foreign Enterprise Permanent Representative Entities” (the “Rep Office Administration Notice") on January 4, 2010.

By the Rep Office Administration Notice the criteria for the grant or renewal of the authorization to open a Rep Office have also been tightened. Accordingly, a foreign company which seeks to set up a Rep Office must show that the foreign company has been set up at least for two years. In the case of a renewal the applicant will need to prove that the foreign company still exists.
Further a limitation has been introduced as to the term of new and renewed Rep Office licenses for one year at a time (compared to the usual three years).

Also the number of foreign representatives in a Rep Office has been affected by the Rep Office Administration Notice. According to the new provisions a maximum of four representatives, including the chief representative, are generally allowed in a Rep Office. The transitional provision for the existing Rep Offices with more than four representatives provides that the Rep Office cannot replace employees in excess of the limit. The limit, however, does not apply to the Chinese staff employed without powers of representation.

It appears that both the Rep Office Tax Measures and the Rep Office Administration Notice have been issued to restrict and discourage the establishment and maintenance of Rep Offices. To mitigate if possible the effects of the new heavier tax burden, existing Rep Offices are advised to investigate whether the Rep Office is still eligible for tax exemption under a treaty or other arrangements. In general the new regulations may be a good reason to consider whether an existing Rep Office should be closed and that it may now be the time to consider a WFOE which may now make even more sense from operational and tax perspectives. It seems in any event that the Chinese authorities are keen to have Rep Offices revert to their initial purpose (i.e. small window offices not actual businesses). Foreign companies wishing to actually do business in China may need to consider establishing a real legal entity.
 

On January 8, 2009, the SAT issued the Interim Implementing Rules for Special Tax Adjustments ("the Rules"), which was a major milestone in China's crackdown on tax avoidance. The Rules introduce the general anti-tax avoidance provision which empowers tax authorities to launch anti-tax avoidance investigations and make tax adjustments on transactions without reasonable business purposes, including treaty shopping, abusive use of tax havens or abusive use of tax treaty benefits. When determining whether a tax arrangement was made to avoid taxes, Chinese tax authorities tend to focus on the substance of the arrangement, no matter what form the arrangement takes. Before making such a decision, the tax authorities will perform a comprehensive examination on a number of factors, including the form and substantive impact of the transactions, the execution date and duration of implementation of the transactions, the transactional methods, the connections between each step of the transactions, and tax consequences.

On April 22, 2009, the SAT then released the Guidance on Establishment of Tax Residence Status for Chinese-controlled Offshore Companies under Effective Management Rules, (“the Guidance”) which had a significant impact on "red-chip" companies and round-trip SPVs. Pursuant to the Guidance, if a Chinese-controlled offshore company is regarded as effectively managed in China, then it would be considered as a Chinese tax resident company and taxed on its worldwide income at the rate of 25%. Accordingly, a red-chip company incorporated in a low-tax region, such as Hong Kong, may be subject to Chinese enterprise income tax on its worldwide income. However, a dividend distribution between a Chinese controlled offshore company and other Chinese resident companies will be entitled to tax exemption treatment.

PRC tax authorities have also tightened their control of offshore companies over their ability to enjoy tax treaty preferential treatments, as witnessed by the strings of regulations issued by the SAT. These regulations cover not only substantive rules such as interpretations of various treaty provisions, but also procedural rules as to how to apply for tax treaty benefits. They impose stringent requirements on the entitlement of treaty benefits for offshore entities. For example, under the Circular on Application of Dividends Provision of Tax Treaties issued by the SAT on February 20, 2009, applicants qualifying for preferential treaty treatment on dividends are subject to certain requirements. In particular, if a recipient of dividends intends to apply the dividend provisions of tax treaties which require a threshold of equity holding (generally 25% or 10%), then such recipient must be a company and must meet the aforesaid threshold both in shares and in voting rights at any time during the 12 months preceding the receipt of dividends. In addition, the SAT's Circular on Interpretation and Determination of Beneficial Owner under Tax Treaties ("Circular No. 601") directs local tax authorities to investigate whether an applicant satisfies the requirements to qualify as a beneficial owner, which is a pre-requisite to enjoying the benefit of reduced withholding tax on dividends, interest, royalties or capital gains under a tax treaty. According to Circular No. 601, a beneficial owner refers to an individual or any organization that has ownership and control over the income or the assets or rights generating the income. An agent or a conduit company is not regarded as a beneficial owner. A conduit company is a company established in a tax-exempt or low tax rate jurisdiction for the purpose of avoidance or reduction of taxes or the transfer or accumulation of profits, and where the company does not engage in substantive business activities like manufacturing, distribution or management.

The competent local tax authority examines whether a person or an organization is a beneficial owner case by case by reviewing the information provided by the taxpayer or through exchange of information protocols, if necessary. The Circular further lists seven types of unfavorable factors. Where any of these factors exist, an individual or an organization may not be recognized as a beneficial owner. Pursuant to these factors, many single-level offshore SPVs will be unlikely to satisfy the requirements for beneficial owners due to lack of substantive operating activities or unjustifiable business purposes.

In terms of procedural rules on applications for treaty benefits, the SAT issued the Administrative Rules for the Provision of Treaty Benefits to Non-residents (Trial) on August 24, 2009. The Rules introduce two different procedures - filing procedures and approval procedures, depending on the types of applications. Approval procedures apply to applications for treaty benefits of dividends, interest, royalties and capital gains. In other words, nonresidents shall make substantial disclosures, submit adequate supporting documents, and obtain the approvals of tax authorities in order to enjoy treaty benefits. Applications for other treaty treatment, such as business profits of permanent establishments or individual service provider, should be subject to filing procedures, under which the applicant or the party subject to withholding tax is required to submit documentation (including tax residency certificate). For the said reasons, it is critical for the applicants to proactively prepare such application documents to properly and sufficiently address the offshore company's economic substance and business purposes.

In practice, Chinese tax authorities published their decisions on two real cases – a Xinjiang case and a Chongqing case. These decisions are clear signals for the tightened scrutiny on offshore SPVs and offshore transactions. In the Xinjiang case, a Barbados SPV acquired shares in a Xinjiang joint venture and subsequently sold the shares for a gain, and tried to avoid withholding tax on capital gains by applying China-Barbados tax treaty provisions. However, the Xinjiang state tax authority rejected the Barbados SPV's eligibility to enjoy the treaty benefits on the ground that the Barbados SPV was not viewed as a tax resident of Barbados and the transaction through the Barbados SPV was for tax avoidance purpose. In the Chongqing case, a Singaporean investor contemplated disposal of its shares in a Chinese subsidiary and thus established an intermediate Singaporean company to hold the equity shares, and later sold the equity shares of the intermediate Singaporean company to a Chinese buyer to avoid paying capital gain tax in China. Chinese tax authorities disregarded the existence of the intermediate holding company in Singapore and imposed withholding taxes over the capital gains realized from the transfer of equity shares or the Singapore holding company.

Companies are advised to watch closely the changes in tax regulatory climate, review their holding structures and offshore transactions, particularly the positioning of offshore SPVs, to mitigate adverse PRC tax exposures and ensure the soundness of both tax compliance and tax efficiency.

According to Circular 601, a beneficial owner refers to a person or any organization that has both ownership and right of control over the income or the assets or rights generating the income. An agent or a conduit company is not regarded as a beneficial owner. A conduit company is defined as a company established in a tax-exempt or low tax rate jurisdiction for the purpose of avoidance or reduction of taxes or the transfer or accumulation of profits, and where the company does not engage in substantive business activities like manufacturing, distribution or management. No further guidance is provided as to what constitutes management activities and whether such activities must be carried out by personnel or may be conducted at board level.

The determination of beneficial owner is to be conducted on a case-by-case basis, based on information provided by the taxpayer when applying for treaty benefits. The Circular further states that the following factors would be unfavorable in determining whether a company is the beneficial owner of an item of income, without indicating how these factors are to be weighed:

(a) The applicant is obligated to transfer all or most of (such as more than 60%) income to   a resident of a third country (region) in the stipulated time period (such as twelve months upon receipt of income);

(b)  The applicant does not or barely engages in other operating activities except for holding the income derived from the assets or rights;

(c)  When the applicant is a company, the applicant’s assets, business scale and personnel could not reasonably match the income;

(d)  The applicant has no or little right of control or disposal of the income or its underlying assets or rights; nor does it assume any or hardly any risks;

(e)  The income is non-taxable or tax-exempt in the other contracting country (region), or even if it is taxable, the tax rate is extremely low;

(f)  The lender to a loan agreement that generates interest income has another loan agreement or deposit contract with a third party; the amount, interest rate, and the time of conclusion with respect to the third-party contract are similar to those of the first loan agreement.

(g)  The licensor to an agreement on copyright, patent, and technology licensing or transfer has a contract to obtain the rights by license or transfer from a third party.

It appears clear that a single purpose vehicle (SPV) set up for a single Chinese investment will not satisfy the requirements for beneficial ownership under the Circular. It is less clear whether a holding company that holds several investment subsidiaries, but does not have its own management personnel, would qualify as a beneficial owner. The local tax authorities appear to have considerable discretion to make that determination, given the broad statement in the notice that a beneficial owner should have substantive business operations, the lack of any weighting in the identified negative factors, and the fact that even a multi-investment holding company would trigger at least two of the criteria set out above, and perhaps one or two more, depending on how these criteria are interpreted.

Companies are well-advised to review their holding company structures immediately, and consider restructuring out of SPVs, assuming they need to take advantage of the dividend withholding tax exemption. Companies with multiple investment holding companies need to exercise caution before applying to distribute dividends, and may consider injecting personnel and operating assets into their holding companies, if feasible, while keeping alert to further developments in the actual enforcement of Circular 601.